Kerry Back
BUSI 721, Fall 2022
JGSB, Rice University
A common misconception is that the “law of averages” will rule in the long run, eliminating risk.
It is true that the average return should not be risky in the (very) long run.
But gambling many times does not eliminate risk. The average gain per gamble may equal the true odds in the long run, but the gain or loss is
average gain per gamble \(\times\) number of gambles.
Note the variation in compounded returns in different simulations
Same exercise as in our first module
But generate a random return each month of the investment lifetime
And simulate many lifetimes in this way
If we want to forecast a constant return (not simulate) and base the return on history, should we use the historical arithmetic average or historical geometric average?
Geometric average is better for forecasting future compounded returns.
Arithmetic average is better for forecasting future (arithmetic) average return.